The financial accounting and reporting (FAR) test of the CPA exam tests your knowledge of several types of liabilities including accrued liabilities, long-term debt, deferred taxes, and pension liabilities.
Accruing liabilities
The accrual basis of accounting recognizes revenue when it’s earned and recognizes expenses when they’re incurred. The accrual basis doesn’t rely on cash deposits to recognize revenue. You aren’t required to write a check to recognize an expense. The terms “earned revenue” and “incurred expenses” are not connected to cash movements in your business.
A customer deposit is considered unearned revenue. When the payment is received, the company debits (increases) cash and credits (increases) a liability account, unearned revenue. The account may also be called customer deposits. The revenue is not earned until the company delivers the product or service. At that point, the firm debits (reduces) unearned revenue and credits (increases) revenue.
If you issue a corporate bond, you’re a creditor, and you recognize interest expense for bond interest. When you post interest expense, you accrue it. You accrue interest expense for any liability that’s charged interest. Here are two related issues that you may see on the FAR test:
Interest payment date after end of period
Non-interest bearing bond or note
Another type of accrual relates to compensating employees. Many companies offer paid vacation, sick days, and other personal days as an employee benefit. Normally, the firm’s benefits manual or website will explain how many days a worker earns as a benefit each year.
Long-term debt
Retirement of debt means that the owner of the debt is repaid and that the debt is removed from the issuer’s financial statements.
The most common debt instrument on the FAR test questions is a bond. Bonds are normally issued at the debt’s face amount, the amount stated on the bond certificate. Face amount is also what is repaid to the investor at maturity. When a bond is retired, the issuer debits (reduces) bond payable and credits (reduces) cash.
The FAR may test a few other situations related to debt retirement. For example, a bond may be issued at more or less than the face amount. Also, some bonds allow the issuer to repay principal over time rather than at maturity. In that case, the issuer isn’t repaying the entire principal balance at maturity; some principal has already been repaid.
Amortizing bonds
A bond is normally issued at its face amount, or par amount, which is the principal amount stated on the face of the bond certificate. In some circumstances, however, bonds are issued at a discount or premium.
With a discount, the coupon rate on the bond is less than the coupon rate for similar bonds that are being issued. A discount is a price that is less than the face amount. The coupon rate is the interest rate stated on the bond certificate.
Keep in mind that the issuer always pays the face amount to the investor at maturity. It follows that the liability created, or bond payable, is always for the face amount of the bond.
Bonds may also be issued at a premium, or at an issue price that is more than par. If the coupon rate on the bond is more than the current market rate for bond of similar quality, the bond is issued at a premium.
Other long-term debts
Two other types of liabilities are frequently tested on the financial accounting and reporting (FAR) test. Both liabilities may be current liabilities (due within a year) or long-term liabilities (payable in a year or longer), but they’re more commonly tested as long-term debts.
A deferred tax liability is a tax payment that is due in a future period. These liabilities occur because of a difference in accounting treatment between a company’s accounting records and the tax return. Accountants also refer to this as a book versus tax difference.
Depreciation is a frequently tested topic with deferred taxes. It’s common to have a depreciation method for the accounting records that’s different from the tax return. Consider the financial impact of using an accelerated depreciation method for taxes and a straight-line method for the accounting records (book):
An accelerated method (like double-declining balance) generates more depreciation expense in the early years than the straight-line method.
Higher depreciation expense in early years lowers net income in the early years.
Lower net income in the early years results in a lower tax liability.
Total depreciation over the asset’s useful life is the same, regardless of the depreciation method chosen. If accelerated depreciation generates lower net income and a lower tax bill in the early years, the business will post more net income and more tax liability in later years. That’s because accelerated depreciation methods post less depreciation in later years.
For deferred taxes, keep in mind that any difference between accounting records and the tax return that results in a different level of net income may create a deferred tax liability. That situation may also create a deferred tax asset. With a tax asset, net income is lower in future years, which creates less tax liability.
Another long-term liability that shows up on the FAR test is pension liabilities. A pension is a series of payments from an investment fund to a retired former employee. Here are two types of plans:
Defined benefit: Defined benefit plans require a company to pay specific dollar amounts to retired employees. It’s the company’s responsibility to invest enough dollars to pay the required pension amounts.
Defined contribution: A defined contribution plan requires the business to invest specific dollar amounts in the retirement plan. The pension payout is based on the investment performance of the retirement plan. The company isn’t obligated to pay a specific pension amount.
Businesses need to consider two calculations for pensions. The projected benefit obligation (PBO) defines the dollar amount that the company must pay at a future point in time. Plan assets, on the other hand, represent the value of the dollars currently invested to meet the PBO. If the PBO exceeds the fair market value of the plan assets, the company needs to recognize a liability for that obligation in the balance sheet.